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The Outperform Case for Select Comfort

To truly measure the performance of a decision, you have to evaluate the input and the outcome.

It doesn't matter to me one bit that that adjustable firmness mattress maker Select Comfort (NASDAQ:SCSS) is a Motley Fool Hidden Gems pick. It has no bearing on my thesis. Only the current circumstances do.

Pretty soon, I'm going to give Select Comfort an outperform rating in Motley Fool CAPS. Since, according to Michael Mauboussin, the top investors focus on the process (launches PDF file) along with the outcome, giving my thesis (a "pitch" in CAPS parlance) before I make my call is the right thing to do. That way I, or any of you, can go back and evaluate the input along with the output. Not only will that allow me to evaluate the decision, but it gives me a record to look back on and learn from.

Not the best of timesSelect Comfort's recent performance has rewarded shareholders the way a baby rewards a diaper. Shares are down 36.5% from their 52-week high and 42% from their April 2006 all-time high. Sales growth continues to decline: 24% in 2005, 17% in 2006, and 11% over the past 12 months. We'll call that suboptimal, because my editor probably won't let the word I want to use go through.

As if Mr. Market wasn't depressed enough, in May, the head of Select Comfort marketing left for "personal reasons." That can be interpreted in many different ways, but the fact is that marketing dollars spent over the past few years have not produced the expected results. In fact, many people have criticized the company for not marketing its value proposition well enough nor to a wide enough audience.

Slumping sales have led to a series of earnings misses and warnings. As expected, Mr. Market simply couldn't handle any more bad news and seems to have given up hope, as shares recently made a new 52-week low.

Great value propositionI bought a Sleep Number bed for my daughter, and she loves it. Her old mattress hurt her back, so we attacked the problem by comparing options and buying one that she could adjust. Don't get me wrong. We tried Sealy (NYSE:ZZ) top-end mattresses, and she absolutely loved the Tempur-Pedic (NYSE:TPX) foam mattress. But in the end, she decided it best to be in control of her comfort at night.

Being in control of your comfort is a powerful value proposition, and not one the company should limit to the older part of the current generation. My daughter is 10, and she makes minor adjustments to get things just right. In fact, I think Select Comfort may have a customer for life now. How come that part of the message doesn't get out? How come I had to figure it out for myself and do all the work to create a potential repeat customer? Isn't that marketing's job?

A missing piece of the competitive-advantage puzzleThe right combination of a good position and the right supporting capabilities creates a competitive advantage. The company has a great product offering: an adjustable firmness mattress. Call it an air mattress if you like, but that's not what the company is selling. It sells a system that delivers comfort to one-third of our lives, the same as Sealy and Tempur-Pedic. It just uses a different technology.

Select Comfort also has a just-in-time distribution system with manufacturing plants (sewing and quilting, as well as final assembly), experienced suppliers, warehouses, and delivery options (UPS (NYSE:UPS) and one in-house). It also has multiple sales channels: its website, mall-based stores, and retail partners. Lately, the missing piece has been a better marketing message to communicate the benefits of its differentiated product to sell through its efficient distribution system.

That's why a new marketing program is going to be a very crucial catalyst going forward. I believe the other pieces of the competitive-advantage puzzle are already in place. If the message of the benefits and the value proposition are not clearly stated to the appropriate people, why should I expect sales to grow faster than the industry average?

Low expectations means low pricesRight now, expectations are low thanks to lots and lots of uncertainty. Are consumers tapped out and willing to defer bedding purchases? Are fewer and fewer people interested in the "glorified air mattress?" Is the growth phase of this company over? Am I just making stuff up?

Well, here's a rundown of some free cash flow growth scenarios to see where we are.

Growth Rate

6%

11%

16%

Equity Value

$11.30

$16.40

$23.80

Author's calculations.

If free cash flow grows at 6% (industry-average sales growth with no margin improvements), then shares are overvalued. The market expects about 11% growth in the current price. Anything higher than 11% causes the stock price to rise.

My CAPS call It's not a screaming buy at these prices, but as the price drops, the bet moves more and more in my favor. And with the potential for the self-imposed recapitalization via the huge share-buyback program, all of those numbers rise as a result of fewer shares outstanding. At prices lower than $14, I wouldn't be able to sleep at night thinking about a great bargain like that.

Nothing miraculous will happen over the next six to nine months, and I'd probably say that this is dead money for sure. The market needs to readjust its expectations for the price to rise. But I don't care about returns over the next six to nine months. I care about returns over the next three to five years. And if I have to put up with dead money or even declining prices in the short term to beat the market over the long term, then that's exactly what I'll do.

Retail editor and Inside Value team member David Meier is ranked 9,656 out of 31,079 rated investors in CAPS. He does not own shares in any of the companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.